Streetwise Professor

March 29, 2016

Vertical Integration in LNG? Strike That: Reverse It

Filed under: Commodities,Economics,Energy — The Professor @ 8:24 pm

The LNG market has taken an even harder fall than the oil market, with prices down from a peak of over $20/mmBTU a couple of years ago to around $4 now. Slower demand growth plus the entry of megaprojects in Australia and the US have done a double whammy. Indeed, some big projects have been canceled of late due to the grim price environment.

Anticipating a growth in supply that was likely outstrip demand growth (but not by as much as has actually happened), in 2014 I predicted that an overhang of cargoes would catalyze the development of the spot market. This is in fact occurring. A larger fraction of the trade is being consummated on a short term basis, and longer term contracts are relying less on oil indexing (which I called a barbarous relic, and analogized to the drunk looking for his car keys under the streetlight) and destination clauses (which limit the ability of buyers to resell gas they don’t need), and more on gas-on-gas pricing and destination flexibility.

This is the beginning of a virtuous cycle by which liquidity begets liquidity, making spot trading even cheaper relative to long term supply contracts. As I referred to it in 2014, whereas in the first 50 years of LNG* it was necessary to rely on long term contracts to achieve security of supply and demand, in the next 50 years liquid markets would provide this security, as has been in the case in oil markets for the last nearly 40 years.

The oil market demonstrates that long term contracts are not necessary to support the financing of very capital intensive upstream energy projects. Further, there will be less of a need for megaprojects for some time (given the supply overhang). What’s more, smaller scale liquefaction facilities are becoming commercially viable. For example, the ex-CEO of Cheniere, Charif Souki, has a well-financed startup that is focusing on developing such projects.

Which means that the next decade of LNG will be an evolution towards a market that looks more like the oil market, or other traded commodity markets.

Some don’t see it that way, and seeing the financial struggles of megaprojects are suggesting a move in the opposite direction. For instance, today in Reuters, Clyde Russell pulls the panic alarm and recommends that LNG firms move to vertical integration:

The industry needs to consider going downstream in order to ensure its long-term viability.

Much like oil companies’ move from producing oil into refining it and then retailing fuels, so too will LNG companies have to find ways to establish a sustainable market that will create and maintain demand for their product.

This means investing in re-gasification terminals in developing nations, along with associated pipeline infrastructure and storages.

It may also mean building gas-fired power plants, transmission grids and or even partnering with companies at the retail level to install gas-powered heating systems in buildings and residences.

In the words of Willy Wonka: “Strike that. Reverse it.” (H/T Number One Daughter.)

There are a lot of reasons for vertical integration, none of which apply in the current LNG market. Neoclassical reasons include double marginalization (monopolies at successive levels of the value chain) or circumventing price controls.

Transactions cost reasons include asset specificity that create a bilateral monopoly problem. A classic example is site specificity, as when a power plant is located at the mouth of a coal mine. This reduces transportation costs, but would subject the mine owner to the opportunism of the power plant owner (and vice versa) if they were separate entities. Integration prevents wasteful haggling over quasi-rents.

These conditions don’t hold in LNG. In fact, the reverse is true. Since LNG can be shipped anywhere in the world, since it is an extremely homogenous commodity, and since there are an increasing number of producers, every producer can deal with many buyers, and every buyer can deal with many sellers. This eliminates double marginalization and asset specificity problems.

Moreover, integration can limit the optionality by tying a seller to a small number of consumers. There is  also a multiple equilibrium issue. If a large fraction of buyers and sellers are tied together via integration (or long term contracts), the spot market is less liquid, making it more costly for the remaining firms to rely on spot sales and purchases: this leads them to integrate (or enter into long term contracts), which reduces of the spot market further.

The LNG market is on the cusp of moving in the opposite direction, which would allow it to exploit optionality more effectively. And optionality is becoming more important as gas generation is becoming more common around the world, not just in Asia and Europe, but in Africa as well. This creates more destination options, and these options are valuable due to uncertainties in supply and demand. To take a recent example, drought in Amazonia has led to an increase in demand for gas generation in Brazil: traders like Trafigura have met the demand by sending cargoes there. When the rains return, the cargoes can find another market. As another example, the Fukushima nuclear disaster led to an increase in the demand for gas in Japan. A Russian supply disruption would lead to a spike in demand in Europe.

Given the inherent variability in gas supply and demand, which vary due to the vagaries of the weather, supply shocks, and myriad other factors, and which are crucially imperfectly correlated geographically, destination options are valuable. Flexibility allows gas to move to places experiencing increases in demand or reductions in supply via pipelines. Vertical integration impedes the ability to exploit these options, and hence destroys value.

Thus, vertical integration is the exact wrong way to go in LNG. The biggest virtue of LNG is that it can be shipped anywhere: why undermine that virtue by constraining shipping options? The deepening of market liquidity, which is proceeding apace, will reduce the transactions costs of exploiting optionality. The silver lining in the current glut of LNG is that is speeding the development of liquidity. Meaning that Clyde Russell’s prescription of vertical integration is the exact wrong response to that glut. The glut increases liquidity. Liquidity enhances optionality. Optionality creates value. Don’t stymie this salutary development. Go with it. It will pay off in both the short term and the long term.

* The first cargo of Algerian LNG was shipped in 1964. The birth of the LNG industry is often dated to that shipment, although LNG had been shipped from the US in the 1950s.

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16 Comments »

  1. The mega projects in Australia are from Coal Seam Gas extraction. All significant new natural gas projects in Australia are offshore – a long way off shore and consequently very expensive to develop. One of them in the North West has just been cancelled for the very reasons that you identify.

    Coal Seam Gas extraction is an environmental and social abomination and should also be cancelled – in perpetuity.

    Comment by Podargus — March 29, 2016 @ 9:30 pm

  2. @Podargus
    If you look at IOC websites for the CSG projects in Australia you will see that besides providing gas these projects make crops and livestock grow and children very happy. Why abomination?

    Seriously though might some arid areas of Australia benefit from the associated water production?

    Comment by pahoben — March 30, 2016 @ 4:55 am

  3. The amount of LNG production coming online in Australia is appalling from the standpoint of progressing grassroots LNG projects. In the last few months Gladstone brought a train on line and Australia Pacific (CSG) brought a train on line and the first train at Gorgan came on line. There are more significant start ups this year. Last I knew the expected increase in capacity of firm projects in Australia was 100 million tonnes/year-a huge amount. Global LNG production in 2014 was maybe 240 million tonnes. Many people would be happy if the Australian Government did cancel all CSG projects.

    Comment by pahoben — March 30, 2016 @ 5:22 am

  4. Floating LNG was all the rage for a few years to allow development of smaller gas fields. Exmar late 2015 completes the first barge mounted LNG facility (500,000 tonnes/year about 75,000 MCFPD inlet) for a project in Columbia (Gazprom was involved) and they finish construction and the project goes south. Now Exmar can’t find interest in the vessel since predatory Australia has destroyed the commercial basis for new LNG projects. Saudi Arabia has ruined the oil market and Australia the LNG market and they should be held responsible by appropriate international authorities (oil and gas workers need to form a global trade union).

    Comment by pahoben — March 30, 2016 @ 6:02 am

  5. Vertical integration is a routine strategic fallacy. Not surprised to hear some lightweight pushing it for an industry with poor margins. It won’t help get better margins in this situation.

    Piece is pretty good but there are a few places towards the end where it seems like there is a confusion of the interests of individual actors versus benefit to producers or consumers in general.

    Comment by Nony — March 30, 2016 @ 9:06 am

  6. My conventional rule of thumb is that the cost to load a tanker with some profit is about $6/mmBTU. That might be out of date.

    While you mention a current market price of $4, is that because cheap new sources of gas are available, new cheap technology for gasification are available, or because producers are taking a bath?

    Or all of the above?

    Comment by Whitehall — March 31, 2016 @ 3:21 am

  7. pahoben – Irony appreciated. Water produced from CSG extraction is usually highly saline. Austrlia has more than enough problems with salinity already. I suppose we could use the CSG to power the desalination process.

    Comment by Podargus — March 31, 2016 @ 2:47 pm

  8. […] But rather than the vertical integration that I suggested, a cogent argument for a different path was made by Craig Pirrong, professor of finance and Energy Markets Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston, in his Streetwise Professor blog (here). […]

    Pingback by COLUMN-LNG can follow oil's footsteps, but not all of the way: Russell | Energy News Corporation — April 7, 2016 @ 1:08 am

  9. […] But rather than the vertical integration that I suggested, a cogent argument for a different path was made by Craig Pirrong, professor of finance and Energy Markets Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston, in his Streetwise Professor blog (here). […]

    Pingback by COLUMN-LNG can follow oil's footsteps, but not all of the way: Russell - HDLS Board — April 7, 2016 @ 1:42 am

  10. […] But rather than the vertical integration that I suggested, a cogent argument for a different path was made by Craig Pirrong, professor of finance and Energy Markets Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston, in his Streetwise Professor blog (here). […]

    Pingback by COLUMN-LNG can follow oil’s footsteps, but not all of the way: Russell – Reuters UK – Stock Market Tamer — April 7, 2016 @ 5:08 am

  11. […] But rather than the vertical integration that I suggested, a cogent argument for a different path was made by Craig Pirrong, professor of finance and Energy Markets Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston, in his Streetwise Professor blog (here). […]

    Pingback by COLUMN-LNG can follow oil’s footsteps, but not all of the way: Russell – Reuters UK – Market Tamer Trade Ideas — April 7, 2016 @ 5:35 am

  12. […] But rather than the vertical integration that I suggested, a cogent argument for a different path was made by Craig Pirrong, professor of finance and Energy Markets Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston, in his Streetwise Professor blog (here). […]

    Pingback by RPT-COLUMN-LNG can follow oil's footsteps, but not all of the way: Russell - HDLS Board — April 7, 2016 @ 6:31 am

  13. I think both Clyde and Craig are right on!. While reading Clyde’s wording stricto sensu may lead to a “vertical integration” interpretation, I guess his argument should be taken more lato sensu.

    The underlying argument is the same: LNG demand growth doesn’t lay as much in long term contracts (a rather saturated market) as it depends on the aggregation of a myriad of small and mid-scale demands arising from countless short and mid-term flexible contracts.

    Unlike oil and other liquid fuels, being a boiling cryogenic, LNG inherently produces boiloff with an accompanying change in composition (ageing). Thus, it’s sort of a “perishable” product.

    Therefore, expanding the demand requires developing a specific “just-in-time” logistics model of LNG storage and breakbulk hubs linking the efficient long-range transportation in large LNG carriers to intermediate storages of a few thousand cubic meters, and to 50 to 500 m3 final user tanks of residential, industrial, trucking and ships consumers.

    Much because of the same logistics challenges, LNG production is rapidly expanding in a myriad of small and midscale facilities.

    You may want to see:

    LNG: Small scale – Big opportunities
    http://www.gastechnews.com/lng/lng-small-scale-big-opportunities/

    LNG and FLNG – Small is beautiful
    https://www.linkedin.com/pulse/lng-flng-small-beautiful-jorge-ferreiro

    Small, Medium or ‘Right-Sized’, Incremental Projects Broaden LNG’s Reach
    http://www.rigzone.com/news/oil_gas/a/137549/Small_Medium_or_RightSized_Incremental_Projects_Broaden_LNGs_Reach

    Comment by Jorge Ferreiro — April 7, 2016 @ 7:03 am

  14. […] But rather than the vertical integration that I suggested, a cogent argument for a different path was made by Craig Pirrong, professor of finance and Energy Markets Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston, in his Streetwise Professor blog (here). […]

    Pingback by RPT-COLUMN-LNG can follow oil’s footsteps, but not all of the way: Russell – Reuters – Stock Market Tamer — April 7, 2016 @ 7:32 am

  15. […] But rather than the vertical integration that I suggested, acogent argument for a different path was made by Craig Pirrong, professor of finance and Energy Markets Director of the GlobalEnergy Management Institute at the Bauer College of Business,University of Houston, in his Streetwise Professor blog (http://streetwiseprofessor.com/?p=9898). […]

    Pingback by COLUMN-LNG can follow oil’s footsteps, but not all of the way: Russell – Yahoo News – Stock Market Tamer — April 7, 2016 @ 1:09 pm

  16. […] But rather than the vertical integration that I suggested, acogent argument for a different path was made by Craig Pirrong, professor of finance and Energy Markets Director of the GlobalEnergy Management Institute at the Bauer College of Business,University of Houston, in his Streetwise Professor blog (http://streetwiseprofessor.com/?p=9898). […]

    Pingback by COLUMN-LNG can follow oil’s footsteps, but not all of the way: Russell – Yahoo News – Market Tamer Trade Ideas — April 7, 2016 @ 1:48 pm

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